Editor's Note: Peter Barnes offers a critique of the OECD's Pillars One and Two proposals; he lauds the OECD's goals but expresses concern that the proposals depend on unrealistic assumptions. David Rosenbloom, in a companion commentary, goes further and says the proposals are too complex to work in today's international tax environment. Both authors1 believe the OECD's goal of increasing source jurisdiction taxation can be achieved in other simpler ways.

For 300 years, the principle known as "the revenue rule" sharply limited collaboration among nations with respect to tax. In the seminal 1729 court decision of Attorney General v. Lutwydge, the United Kingdom courts refused to enforce a bond for Scottish tobacco duties. Five decades later, in 1775, the well-regarded Lord Mansfield said in the case of Holman v. Johnson that "no country ever takes notice of the revenue laws of another."

The revenue rule continued to dominate tax jurisprudence among sovereign nations until very recently. Courts in numerous countries (the United States, Canada, India, Sweden and more) followed the revenue rule and refused to allow their courts and laws to be used to enforce the tax rules of another country.

But then came OECD/G20 Base Erosion and Profit Shifting (BEPS) Project. And Pillar One. And Pillar Two.

Progress takes many forms, and a centuries-old principle that each nation will adopt, apply and enforce its tax rules without regard for (or help from) other nations is certainly outdated. Tax treaties are strong evidence that cooperation and coordination among and between nations is essential in promoting the welfare of all jurisdictions.

But just as political movements can move too far in one direction, before swinging back toward a stable center, so too can tax movements. And the effort to ensure a "fair and stable" international tax order through Pillars One and Two is a powerful example of the desire for international cooperation moving too far in the direction of ambitious collaboration.

The motivations for Pillar One and Pillar Two are sensible, even laudable:

  • Providing for additional source jurisdiction tax revenue, particularly from businesses that can engage in large-scale operations in market jurisdictions without triggering the traditional tax nexus that would subject the taxpayers to net-basis income taxation in the market jurisdictions (Pillar One).
  • Encouraging global cooperation among jurisdictions to avoid the dreaded "race to the bottom" in which taxpayers are given reduced tax burdens and jurisdictions are left with insufficient revenues to address public needs (Pillar Two).

In their eagerness to address these two concerns ― legitimate, important concerns ― tax professionals have fashioned the two Pillars that completely turn the long-standing revenue rule on its head. Pillar One throws out national tax rules completely and fashions an entirely new, entirely global, system of tax calculation (based on financial accounting rules) and parcels the revenue to almost all of a taxpayer's market jurisdictions. Pillar Two requires jurisdictions to cooperate intensely, on a taxpayer-by-taxpayer, jurisdiction-by-jurisdiction basis to ensure that not one item of income is taxed at less than 15%.

This pursuit of perfection is well-intentioned, but, in my view, misguided. Grand ambitions can be valuable. But grand ambitions often mean that modest successes are viewed not as progress, but as failures, because the grand ambition is not realized. And grand ambitions can crash and burn.

There is much that can be achieved with respect to the goals of the Pillars project. We believe real progress can be made in finding new ways to increase revenues for source jurisdictions. We believe real progress can be made in reducing the collective action problem in which each jurisdiction reduces its tax rates to become more competitive, with no overall gain to competitiveness, public finance or the global economy.

But by erecting the complex schemes of Pillars One and Two, and setting the bar so high for success, the OECD and participating jurisdictions create a standard that is not likely to be met. That result jeopardizes the real progress that is potentially achievable.

What can be also noted is that this focus on international cooperation in tax ignores identical concerns with respect to domestic tax rules. With the long-standing revenue rule demolished under the Pillars, not only will jurisdictions assist each other in enforcing their tax goals, but a complex web of work-arounds and penalties are erected among nations that do not exist even within nations. In the United States (the US), for example, Pillar Two rules would ensure that a taxpayer cannot arbitrage the tax rules of, say, Bermuda and France, while completely ignoring any arbitrage between New York and Florida.

There may be political advantages in tackling tax challenges outside a country's borders, rather than within the nation, but the irony cannot be overlooked.

This article identifies four unrealistic elements of the two Pillars and suggests alternatives that are more likely to achieve the goals intended.

1. Financial Accounting

Both Pillar One and Pillar Two rely on income as determined under the financial accounting statements of taxpayers, not accounts computed under the tax accounting rules that apply in either the home jurisdiction or the market jurisdiction. For Pillar One, the amount of income that will be redistributed for taxation in the market jurisdictions is derived solely from a taxpayer's financial statements. For Pillar Two, the calculation whether income is subject to a 15% tax rate will likewise be based on financial accounting.

The potential problems are significant.

The OECD's decision to use financial accounting statements ― usually, but not always, determined under Generally Accepted Accounting Principles (GAAP, the US) or International Financial Reporting Standards (IFRS, the rest of the world) ― is not surprising. The OECD is seeking to find a common denominator for these important calculations. Tax accounting rules vary significantly among jurisdictions. Depreciation schedules, bad debt rules, inventory accounting, and many other tax accounting rules differ from jurisdiction to jurisdiction.

In seeking to find a common denominator, however, the OECD missed the mark. The differences between GAAP and IFRS are well-known, but there is not even a single IFRS standard; each jurisdiction can (and does) adopt special rules in applying IFRS. There simply is no common denominator for the calculation of a company's income.

Further, the purpose of financial accounting is different from the purpose of tax accounting. Financial reporting is intended to give investors a clear picture of a company's financial status; companies have flexibility in how they portray their business, at least within limits. For financial reporting, guesstimates are expected. The rules for tax reporting are much more rigorous and intended to determine a single number ― the annual tax liability for the entity.

What can go wrong when the Pillars use financial reporting to determine tax liabilities? Plenty.

First, and most importantly, there is a risk that taxpayers will skew their financial reporting ― in legitimate ways, by for instance adopting different depreciation practices ― if the results yield a lower tax liability. The United States had exactly this experience when tax rules that applied between 1987 and 1989 used financial accounting income to determine tax liabilities for certain corporations. Tax economists conducted studies that demonstrated taxpayers changed their financial accounting practices; accounting professionals and investors worried that financial statements were less reliable and less useful.2 The US eliminated the tax rule after three years.

Second, taxpayers with comparable financial profiles will pay different amounts of tax, depending on which jurisdiction they are in and therefore what financial accounting rules apply. It is silly to believe that two multinationals with more than EUR20 billion in revenue (the group to which Pillar One applies) could have identical financial profiles; that will not happen. The important point is that a US company following GAAP and a German company following IFRS (as adopted by Germany, which is different from IFRS as applied in, say, Japan) will pay different amounts of tax, solely because of accounting rules. Is that logical? Is that fair?

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1. Mr. Rosenbloom is a partner and Mr. Barnes is of counsel to the law firm of Caplin & Drysdale, Chartered

2. For a comprehensive review of the economic literature and the difficulties of using financial statement information to compute tax liabilities, see Mindy Herzfeld (2020). Taxing Book Profits: New Proposals and 40 Years of Critiques. 73 National Tax Journal 4.

Originally Published by Belt and Road Initiative Tax Journal

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.